A rough road still lies ahead for small banks

These aren't the companies that come to mind when you think of banking.

They don't have branches at every major intersection or ads splashed across billboards or television. Their top executives typically don't travel by private jet. Most didn't receive any federal bailout money.

But what the many small banks in Arizona have shared with their large rivals is an inability to avoid fallout from the soft economy and weak real-estate values.

The dozens of small financial institutions that serve metro Phoenix and outlying communities weren't ready for the steep housing downturn or the credit paralysis that followed. Most are bracing for a crisis if commercial property values unravel much further.

Saddled by high exposure to real estate, more than 80 percent of the small banks based here are losing money, and their debilitated status could curb lending in general and blunt the economic recovery.

Phoenix-based Desert Hills Bank was shut down Friday, and seven other banks operating in the state have failed over the past year. Arizona's banking industry ranks among the weakest in the nation in measures such as higher percentage of non-performing loans, highest number of unprofitable institutions and lowest return on equity.

Specialty players

About half of the smaller banks doing business in Arizona are actually based in the state, with local headquarters and their own boards of directors. Roughly another half are run by out-of-state institutions.

For the most part, what they share is a modest local presence.

With small staffs and few branches, these financial institutions clearly aren't all things to all people. They cater to small-business customers or the wealthy. They go by descriptions such as community banks, small-business banks and private banks.

"We all try not to compete against the big consumer banks," said Dan Stewart, Arizona market president for Mutual of Omaha Bank. "So you end up with a business, private-banking or wealth-management touch."

The acute pain felt by small banks has allowed the Big Three mass-market giants - Chase, Wells Fargo and Bank of America - to grab market share.

The big players insist they have money to lend, at least to creditworthy customers, and that's a claim many small institutions can't make right now.

When banks suffer losses, they must raise more capital to back up their remaining portfolios. The big national banks had access to federal bailout aid and can tap capital in various ways. That's not true for most small players. When a bank's capital falls too low relative to its loans, the entity is at risk of being shut down by regulators.

Small banks like to portray themselves as Davids to the Goliaths of Chase, Wells Fargo and Bank of America, which is true from a size standpoint.

But if you're looking for a true banking underdog like the Jimmy Stewart character in the film "It's a Wonderful Life," that image is better represented by credit unions, most of which more closely resemble grass-roots organizations serving middle- and low-income customers.

Most community, business and private banks, by contrast, are upscale and focused on serving the entrepreneurs who so closely resemble their own shareholders.

"Banks that call themselves community banks do so mainly for marketing reasons," said Ernie Garfield, head of Interstate Bank Developers in Scottsdale.

Garfield has helped organize 31 banks in Arizona and in other states, with the proposed Paradise Valley National Bank and a few others in the works.

They're not trying to serve the broad local community, he said.

Entrepreneurial bent

Still, these institutions do play key roles locally.

When a small bank forms, it's common for perhaps 100 to 200 local entrepreneurs and business owners to pool their capital, chipping in anywhere from several thousand up to a few hundred thousand dollars each, Garfield said. These shareholders then help pitch lending and other services to other local entrepreneurs.

"That's the whole idea," Garfield said.

The impact of small banks does extend beyond country clubs and chambers of commerce. These entities historically have played a role helping small businesses, which create most of the new jobs in metro Phoenix and and nationally.

They have relatively high exposure to Arizona real estate because that's been one of the state's main economic drivers. They hold loans on housing developments, office buildings and many other commercial properties. They also extend individual residential mortgages to small-business owners and other upscale clients.

Their futures are intimately tied to Arizona's future. And unlike the national and some regional players, which can shift around money, these banks recycle nearly all their revenues back into the state.

"If you only have a location in Arizona, you can only make loans in Arizona," said Tanya Wheeless, president and chief executive officer of the Arizona Bankers Association in Phoenix.

Loyal following

Many small banks have generated a loyal following at a time when the reputation of bankers overall seems only a bit better than that of petty criminals.

Andrew Buresh, a doctor and co-owner of Desert Springs Cancer Care Center in Scottsdale, recounts how he and partner Lesley Meng tried to get a business loan in 2008, at the height of the credit crisis. After being rejected by two of Arizona's biggest banks and six others, they received a loan from Arizona Business Bank.

"Those people helped us when we needed it," said Buresh, whose firm now counts 10 employees, aside from him and Meng. "Their lending created jobs, which is what it's supposed to do."

Scott Hanson, president of HMA Public Relations in Phoenix, uses Western National Bank for his firm's needs, which include deposits, a loan obtained a few years ago and foreign wire transfers.

"I know them by name, and they know my name," Hanson said. "I don't know if you can walk into Wells Fargo and chat up the president."

Jeremiah Foster practically gushes when describing the service at MidFirst Bank. "They'll try to do anything they legally can to help us," he said. "They understand our business cold."

Foster, who runs Resolute Commercial Services, a Scottsdale real-estate services firm, also uses Western National and praises it for good service, too.

Retrenchment

Although the big banks dispute it, officials at small entities insist they are easier to work with on loans and in building relationships. But at the moment, that claim is challenged because so many small banks - weakened by bad loans and unable to raise enough capital to support more lending - have retrenched.

Arizona already is a highly concentrated state for banking, with 66 percent of deposits held by Chase, Wells Fargo and Bank of America. To the extent that small rivals are marginalized, the market could be focused even more narrowly.

"Anytime you lose competition and have fewer choices, it matters," said Dino Camuñez, president and CEO of First Western Trust Bank, a Scottsdale private bank. "The big banks have shown their true colors lately."

Yet the big players are perceived as more stable, under the assumption federal regulators won't let them fail.

Plus, these banks are better diversified than small ones since they cater to a broad range of customers, operate in many states and offer the gamut of products and services.

Wells Fargo, for instance, has 81 lines of business, said Dean Rennell, a regional president for Arizona business banking. "We do business in many states, so we have diversification of risk and geography."

Rennell disputes the notion that smaller banks are more personal. Wells Fargo, he said, assigns a "relationship manager" to each small-business client and makes local lending decisions in Arizona. It also ranks as Arizona's small-business lending leader, he said.

Recovery?

What will pull small banks out of their downward spiral? The biggest help would come from an economic recovery and stabilizing home prices, with no new shocks from a teetering commercial-property market.

"It's like a wound that takes time to heal," said Camuñez of bank ills.

Garfield also believes many banks need to install more prudent executives and get improved oversight from directors. "You need better governance and better checks and balances," he said.

For example, he suggests that banks split up their CEO and chairman positions so that boards don't wind up as rubber stamps of management.

Another factor affecting banks has been the tone of regulation.

As the downturn intensified, government inspectors got tougher in terms of forcing banks to deal with loan problems faster.

"They're often not willing to give banks time, and that's what our banks need most," Wheeless said.

Banks also have been forced to pay higher premiums to shore up the depleted FDIC insurance fund, hurting their bottom lines even more.

The industry is bracing for more failures this year, with the FDIC having placed roughly 700 national institutions on its troubled-bank list. The banks aren't named, to avoid inciting panic.

Aside from Desert Hills, the seven banks operating in Arizona that failed within the past year included five based here: Community Bank of Arizona, Union Bank, First State Bank, Bank USA and Valley Capital Bank. At the time they went under, those five had amassed $27 million in combined losses for the year to date.

The other casualties were Irwin Union and Amtrust Bank, which were headquartered elsewhere.

Given the threat of more failures, it's important for small-bank customers to make sure their money is FDIC-protected, especially those people with close to or more than $250,000 on deposit at any institution.

Fresh focus

Eventually, the banking industry here will get back on its feet, and there's reason to think the survivors will emerge healthier.

"You can make a case for small banks," said Manolo Sanchez, president and CEO of BBVA Compass, which ranks fifth in terms of Arizona deposits.

But for those banks to succeed, Sanchez said he considers it critical for them to find a niche, be prudent, take a long-term focus and outsource what they can to cut costs.

Garfield, who has a handful of new-bank applications in the pipeline, considers now to be the best time he's ever seen to start a new institution.

Why so? "Because you can start with a clean book and learn from the mistakes of others," he said.

*Desert Hills Bank was shut down by banking regulators Friday and its assets purchased by New York Community Bank.

Source: Call reports filed with the FDIC. Notes: Figures are latest available, generally as of Dec. 31, 2009. The capital-leverage ratio reflects whether a bank has adequate capital. It is calculated by dividing a bank's capital by total assets. Higher figures are better.